“No
one will lend at a negative interest rate; potential creditors will simply
choose to hold cash, which pays zero nominal interest.”

–
Ben Bernanke, 2009

“I
think negative rates are something the Fed will and probably should consider if
the situation arises.”

–
Ben Bernanke, December 2015

“In
theory there is no difference between theory and practice. In practice there
is.”

–
Yogi Berra

Economists
used to think below-zero interest rates were impossible. Necessity (as central
banks see it) is the mother of invention, though; and multiple central banks
now think negative rates are a necessary step to restore growth.

Are
they right? Will negative rates pull the global economy out of its funk?
Probably not; but for better or worse, several central banks are already below
zero. The Federal Reserve just sent its clearest signal yet that it is headed
that way, too. The Fed has warned banks to get ready. We had all better do the same.

This
week’s letter has two parts. The first deals with some of the practical aspects
of negative rates and what the Fed is really signaling. The second part, which
is somewhat philosophical, deals with why
the Fed will institute negative rates during the next recession. This letter is
longer than usual, but I think it’s important to understand why we will see
negative rates in the world’s reserve currency (and the currency in which most
global trade is conducted). This policy trend is truly a foray into unexplored
territory.

Be Careful What You Wish For

The idea of negative rates isn’t
new; what’s new is the willingness to try them out. The Ben Bernanke quote
above comes from a November 2, 2009, Foreign Policy article
in which the Fed chairman wrestled with how to keep inflation at the “right”
level in a weak economy.

Set
aside the question of whether there is any “right” level of inflation. As of
six years ago, the head of the world’s most important central bank thought no
one would ever lend at a negative interest rate. We now know he was wrong, at
least with regard to Japan and most of Europe. Central banks there have
instituted negative rate policies, and people are still borrowing and lending.

The
Fed staff has also speculated on the possibility. Earlier this month my good
friend David Kotok sent around links to several academic and central bank
negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie
McAndrews of the Federal Reserve Bank of New York. Their title tells you what
they thought at the time: “If
Interest Rates Go Negative… Or, Be Careful What You Wish For.”

Their
point was less about the theoretical wisdom of NIRP and more about the actual
potential consequences. They believed we would see a variety of odd responses
to a very odd policy situation. All kinds of incentives would reverse, for
starters.

Under
negative deposit rates, buyers would want to pay their invoices as soon as
possible, while sellers would want to delay receiving cash as long as possible.
Think about your credit card bill. If you normally spend $10,000 a month, your
best move would be to send the bank that much money before you spend it, then draw down the
resulting credit balance. The bank would no doubt try to discourage this
practice.

Could they? We don’t know.

Garbade
and McAndrews throw out another interesting idea: special-purpose banks:

If
rates go negative, we should expect to see financial innovations that emulate
cash in more convenient forms. One obvious candidate is a special-purpose bank
that offers conventional checking accounts (for a fee) and pledges to hold no
asset other than cash (which it immobilizes in a very large vault). Checks
written on accounts in a special-purpose bank would be tantamount to negotiable
warehouse receipts on the bank’s cash. Special-purpose banks would probably not
be viable for small accounts or if interest rates are only slightly below zero,
say -25 or -50 basis points (because break-even account fees are likely to be
larger), but might start to become attractive if rates go much lower than that.

Ludwig
von Mises fans will recognize that this approach is not far from the Austrian
economics goal of 100% reserve banking. It isn’t quite there because the vault
contains fiat currency instead of gold, but I think Mises would recognize it as
a step in the right direction. (The fact that Fed economists see it only as an
exotic theoretical possibility wouldn’t surprise him, either.)

The
consequences of such banking would be more than theoretical. If enough people
wanted to use these special-purpose banks, demand for physical cash would go
through the roof. There simply wouldn’t be enough to go around if it just sat
in vaults instead of circulating. Furthermore, if the vaulted cash in these
banks reduced deposits in normal loan-making banks, the whole banking system
might grind to a halt.

That
being the case, I suspect the Fed would prohibit banks from operating this way
– but they can’t stop people from hoarding cash under their mattresses. The one
thing they could
do is eliminate physical cash. Denmark, Sweden, and Norway are already
considering ways to do so.

Even
more ominously, Bloomberg reported on. Feb. 9 that a move is afoot for the
European Central Bank to get
rid of 500-euro notes, the Eurozone’s largest-denomination bills. They
portray this move mainly as a crime-fighting measure, but it would clearly make
cash hoarding much more difficult.

And if
Larry Summers and a few other well-known economists like Ken Rogoff have their
way, we will see the demise of the $100 bill in the US. You thought you were
just carrying those Ben Franklins around for convenience, not realizing that
they make you a potential drug dealer in some people’s eyes.

And of
course, hoarding cash would undermine the Fed’s goal of fighting deflation.

Holding cash is by definition deflationary.

If Crazy Doesn’t Work, Try Crazier

All of
the above is just speculation at the moment. We don’t know how deeply negative
rates would have to go before people change their behavior. So far the negative
rates in Europe and Japan apply mainly to interbank transactions, not to
individual depositors or borrowers. Unless of course you are buying government
bonds.

That
said, we’ve seen a clear tendency on the part of central banks since 2008: if a
crazy policy doesn’t produce the desired results, make it even crazier. I
believe Yellen, Draghi, Kuroda, and all the others will push rates deep below
zero if they see no better alternatives. And my best guess is they won’t.

Turns
out negative rates aren’t exactly new. My good friend David Zervos, chief
market strategist for Jefferies & Co., sent out a note this week pointing
out that many “real,” inflation-adjusted rates have actually been negative for
years. Such rates have thus far not produced the kind of reflation that central
banks want to see. David thinks the ECB and BOJ should push nominal rates down
to -1%, launch new quantitative easing bond purchases of at least $200 billion
per month, and commit to do even more if their economies don’t respond.

Is
Zervos losing his mind? No, he actually makes a pretty good case for such a
policy – if you buy into his economic theories, which I discuss in the second
part of this letter. (Over My
Shoulder subscribers can read Zervos’s note here.)
It is painfully clear to most of us that what the central banks have done thus
far has not worked. I have a hard time imagining that a major NIRP campaign
will help, but I’ve been wrong before.

Former
Minneapolis Fed President Narayana Kocherlakota, who was for years the FOMC
uber-dove, says going negative would be “daring but appropriate.” He has a
number of reasons for this stance. In a
note last week, he said the federal government is missing a chance to
borrow gobs of money at super-attractive interest rates.

Kocherlakota
would like to see the Treasury issue as much paper as it takes to drive real
rates back above zero. He would use the borrowed money to repair our rickety
infrastructure and to stimulate the economy.

It is
an appealing idea – in theory. In reality, I have no faith that our political
class would spend the cash wisely. More likely, Washington politicians would
collude to distribute the money to their cronies, who would build useless
highways and bridges to nowhere. The taxpayers would end up stuck with more
debt, and our infrastructure would be little better than it is now.

The
fact that this is a “monumentally” bad idea doesn’t mean it will never happen.
There’s an excellent chance it will
happen. Yellen and the Fed are clearly looking in that direction.

Yellen & the Spirit of Prudent
Planning

Yellen
might face one small problem on the road to NIRP: no one is completely sure if
the Fed has legal authority to enact such a policy. An Aug.
5, 2010, staff memo says that the law authorizing the Fed to pay interest on excess
reserves may not give it authority to charge
interest.

This
potential snag is interesting for a couple of reasons. With last month’s
release of this memo, we now know the Fed was actively considering NIRP less
than a year after Bernanke himself said publicly that “no one will lend at a
negative interest rate.” Meanwhile, some at the Fed were clearly examining the
possibility.

What
else was happening at the time? The bond-buying program we now call QE1 had
just wrapped up in June 2010. The Fed launched QE2 in November 2010. This memo
came about because the Fed realized it needed to do more and was considering
options. QE2 apparently beat out NIRP as the crazy policy du jour.

The
question of the legality of negative rates came up again in congressional
testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked
Yellen if the Fed had authority to impose negative interest rates. According to
press
reports, she skirted a definitive answer:

In
the spirit of prudent planning we always try to look at what options we would
have available to us either if we needed to tighten policy more rapidly than we
expect or the opposite. So we would take a look at [negative rates]. The legal
issues I'm not prepared to tell you have been thoroughly examined at this
point. I am not aware of anything that would prevent [the Fed from taking
interest rates into negative territory]. But I am saying we have not fully
investigated the legal issues.

We
know the Fed was
investigating the legal issues as long ago as 2010. I would be shocked to learn
that they did not investigate those issues thoroughly in the six subsequent
years. Various Fed officials – including Yellen – have openly speculated about
NIRP. The Fed’s legal team should be disbarred for malpractice if it hasn’t fully investigated
yet. I think Yellen’s testimony was a way to deflect the potential controversy
as long as possible. I believe the Yellen Fed will telegraph the markets about
negative rates prior to implementing them, but evidently Yellen feels it is too
soon to send that signal now.

Of
course, Yellen also says she is “not aware of anything that would prevent” a
NIRP move. So she may do it and then blame her lawyers if someone cries foul.
By then the policy would be in place and probably irreversible. In Washington,
forgiveness comes easier than permission does.

In the
same testimony, Yellen hinted that the previously forecast March rate hike is
probably off the table now. We will get new “dot plot” forecasts, though. It
will be interesting to see how dovish they are.

As
I’ve said, I am firmly convinced that the Fed will not raise the federal funds
rate even to 1% this year. December may well have been the last hike we will
see for some time. I can see the Fed holding steady for several months. And
they are clearly getting ready to introduce negative rates during the next
recession. They are already telling banks to get ready for them, too.

Y2K All Over Again?

The
Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major
banks. They do this by giving the banks a set of hypothetical economic
scenarios. They released this
year’s scenarios on Jan. 28.

The
“severely adverse” scenario instructs banks to test their systems for a deep
recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%,
and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.

Is
this “severely adverse?” It’s far less adverse than what Japan has already
experienced. BOJ purchases have driven Japanese government bond yields negative
10 years out the curve. Rates are also negative far out the yield curve all
over Europe, even in countries that don’t deserve such rates, let alone midterm
rates with even a one or a two handle.

The
stress test scenarios aren’t a forecast, per se, but they mean the Fed at least
sees those conditions as possible. The whole exercise is pointless if the
scenarios could never happen. I think this stress test scenario is the clearest
sign yet that the Fed views NIRP as a legitimate alternative.

It
doesn’t mean NIRP is guaranteed. I believe Yellen when she says their policy is
“data-dependent.” They are no more prescient about the future than the rest of
us are. All they can do is look at the data and try to respond appropriately. I
don’t envy them that job.

I
think the Fed is right now in a position much like the one that was portrayed
in that 2010 staff memo. They see their last big move as not having had the
desired effect and are considering a new set of options. NIRP is on their list.

Having
decided to put NIRP on the list, the Fed has to make sure the banking system
can handle it. Whether it can is far from clear right now. The technology
issues alone could unleash chaos if the Fed went negative without warning. I
think putting negative rates in the stress test scenarios is the Fed’s
not-so-subtle message to Wall Street: “Get ready; this could really happen.”

Widespread
negative interest rates, once only a theoretical possibility, have become a
real-life problem for Europe’s financial system.

From
Sweden to Spain, banks, brokers and other financial firms are grappling with
technical and legal glitches thrown up by negative rates, forcing them to
redesign computer systems, tear up spreadsheets and redraft legal contracts.

The
issue echoes the scrambles around the Year 2000 computer bug and the launch of
the euro, when some bank systems couldn’t handle the introduction of a new
currency, said Kevin Burrowes, head of U.K. financial services at
PricewaterhouseCoopers. A handful of malfunctioning computer programs can cause
“huge problems,” while working around problems manually makes more controls
necessary and increases the risk that something could go wrong, Mr. Burrowes
said.

Preparing
for NIRP is a far smaller challenge than preparing for Y2K, which required
years of reprogramming and hundreds of billions of dollars, but it is still a
huge project. Some reports say European banks are still dealing with the
programming issues. And technology is only part of the problem. Think of all
the contracts and other legal documents that might need rewriting and
renegotiation. If nothing else, the Fed just stimulated the securities and
contract law businesses.

One
small example from my personal experience: I have been involved in the
management of several large commodity funds over the past 25 years. Back in the
day, commodity funds had a significant advantage in that they could put 90% of
their money into short-term government bonds to generate the capital for their
futures contracts. This interest offset a lot of their fees in the ’80s and
’90s. Not so much today. I suspect that many of the organizational documents
required still state that such funds will use short-term Treasuries as their
cash base.

Requiring
these funds to lose ½% would mean they start in the hole. Not what a fund
manager wants to do. But it has to be short-term cash, as the money has to be
available on very short notice since it’s the collateral for a futures
contract. I’ve sat and thought about this and still haven’t come up with a way
around this. I wonder how many other funds will have the same issue. (We will
discuss this subject in further depth in a few paragraphs.)

Go Thou and Do Likewise

The
Fed is specifically warning banks, but NIRP will affect the whole economy. If
you own any kind of business or you are an active investor, I expect that NIRP
will create significant headaches for you. Are you ready?

Most
of us have no idea whether we’re ready, but we might be able to find out.
Here’s a simple test. Go to whatever accounting software or spreadsheet program
you use, find the interest rate setting and see if it will let you enter a
negative number.

If it
won’t accept a negative rate at all, now might be an excellent time to update
your software.

If the
program does let you show a negative rate, dig a little and see how that rate
affects the rest of your bookkeeping. Most of us have created numerous Excel
spreadsheets. You know that if you get your programming off a little bit, you
end up with ##### signs in some of the cells. When you enter negative
interest rates into your software, you may find similarly weird things
happening. They could be good-weird or bad-weird, but in either case you might
want to consult your brokerage firms, investment advisors, accountants, and tax
advisors about possible consequences.

While
you’re at it, think about how the rest of the Fed’s “severely adverse” scenario
might affect you. Here is the guidance the Fed gave the Banks:

(Yes,
I know they spelled severely
wrong. Clearly the Fed needs a new proofreader along with new policies. That
said, you just can’t catch all the mistakes. There are at least three
professional editors who read my letter prior to publication, and misteaks
still happen.)

I
didn’t even mention the Fed’s stock market scenario in the right column above.
It shows the Dow dropping almost to 10,000 by the end of this year and
recovering very slowly. In a world where anything is possible, I suppose it is
prudent to ask what if
questions. I do not see the Dow’s dropping 10,000 points this year, but in a
deep recession? That plunge would not be out of the realm of historical
precedent. If banks are planning for adverse scenarios, it would be a good idea
for you to do so, too, even if you think there is no chance in hell those
scenarios will play out. Contingency planning is simply prudent management.
Don’t let a recession catch you without a plan.

The Religion of Economics

The
problems posed by negative rates are mostly practical in nature, but they come
with some deeply disturbing side effects. In the discussion above I didn’t
venture into the theoretical problems of misallocation of capital, the negating
of Schumpeter’s creative destruction cycle, the even more intense repression of
savers and retirees, and the absolute devastation negative rates would wreak up
on pension, endowment, and insurance company portfolios.

In a
world of ultralow rates, pension funds that are targeting 7½% growth in order
to meet their funding needs 20 years out will find those targets are impossible
to attain (as they are today, only moreso). It is not yet obvious to the
general public how deeply underfunded pensions are, because pension funds are
still assuming that future returns will be in the 7½-8% range. That pension or
annuity you are counting on for your retirement is most likely in serious
trouble. And as people get older and have no practical way to go back to work,
pension funds that are forced to reduce payments in 10 or 15 years (and some
even sooner) will destroy the lifestyles of many of our elderly. You think
there is a violent backlash among voters today? Just screw around with
pensions…

So
what would make central bankers around the world agree that negative rates are
a solution to our current economic malaise? And that, with all their known negative consequences,
not to mention their unknown
unintended consequences, negative rates are better than the
alternative?

I have
been trying to devise an explanation of the negative rates proposition that
most people can grasp by likening prevailing economic theories to a religion.
Everyone understands that there is an element of faith in their own religious
views, and I am going to suggest that a similar act of faith is required if one
is believe in academic economics. Economics and religion are actually quite
similar. They are belief systems that try to optimize outcomes. For the
religious that outcome is getting to heaven, and for economists it is achieving
robust economic growth – heaven on earth.

I
fully recognize that I’m treading on delicate ground here, with the potential
to offend pretty much everyone. My intention is to not to belittle either
religion or economics, but to help you understand why central bankers take the
actions they do.

This
explanation will need a little set-up. I have noted before, in an effort to be
humorous, that when you become a central banker you are taken into a back room
and given gene therapy that makes you always and everywhere opposed to
deflation. Actually, this visceral aversion is imparted during academic
training in the generally elite schools from which central bankers are chosen.

This
is our heritage; it’s learning derived not only from the Great Depression but
from all of the other deflationary crashes in our history, too, not just in the
US but globally. When you are sitting on the board of a central bank, your one
overriding rule is never to allow deflation to occur on your watch. No one
wants to be thought responsible for bringing about another Great Depression.

And
let’s be clear, without the radical actions taken in 2008–09 to bail out the
banks, drop rates to the zero bound, and institute quantitative easing, we
would likely have been facing something similar to the Great Depression. While
I don’t like the manner in which we chose to bail out the banks, some form of
bailout was a necessary evil.

Think
deflationary depressions can’t happen today? Clearly, they can. Greece, for all
intents and purposes, has sunk into a massive deflationary depression. That
reality is not necessarily reflected in the prices of their goods, which are
denominated in euros. No, the deflationary depression in Greece is in their
labor market.

Normally,
when a sovereign country gets into financial trouble (generally because of too
much debt), it will devalue its currency so that the prices of products it
imports go up and labor costs and the prices of products it sells abroad go
down. But since Greece could not devalue its currency (the euro), it was
essentially forced to allow its labor costs to fall drastically. Since it is
basically impossible to go to everyone in Greece and say, “You need to take a
25% cut in your pay, even though the prices of everything you’ll be buying will
still be in euros,” the real world simply produced massive Greek unemployment –
precisely what you would expect in a deflationary depression. Greece will
likely continue to suffer for a very long time, whereas if the Greeks had left
the euro, defaulted on their debts, and devalued their currency, they would
likely be enjoying a quite robust recovery.

Greece’s
present is a possible near future for other countries in Europe (Portugal is
likely to be next, and Italy will surprise everyone with its severe banking
problems), which is why the European Central Bank is so desperately fighting
the deflationary impulse embedded in the very structure of the European Union.

Now,
the United States is clearly not Greece. However, we are subject to the same
laws of economics.

By
definition, recessions are deflationary. Whenever we enter the next recession,
we are going to do so with interest rates close to the zero bound. Most of the
academic research both inside and outside the Fed suggests that quantitative
easing, at least in the way the Fed did it the last time, is not all that
effective. If you are sitting on the Federal Reserve Board, you do not want to
allow deflation to happen on your watch. So what to do? You try to stimulate
the economy. And the one tool you have at hand is the interest-rate lever.
Since rates are already effectively at zero, the only thing left is to dip into
negative-rate territory. Because, for you, allowing a deflationary malaise to
set in is a far worse thing than all of the potential negative consequences of
negative rates put together. It’s a Hobson’s choice; you see no other option.

Let’s
do a little sidebar here. There’s lots of discussion in the media of the
possible moves the Federal Reserve could make. Some people talk about the Fed’s
buying the government’s infrastructure bonds, or buying equities or corporate bonds,
or even doing the infamous “helicopter drop” of money into outstretched
consumer hands. Those are not legal options for the Fed. The Fed is actually
fairly restricted in what it can purchase. All of these outside-the-box
transactions would require congressional approval and amendment of the Federal
Reserve Act.

I can
tell you that there is almost no stomach in the leadership of Congress or at
the Fed to bring up the Federal Reserve Act for congressional action. Everyone
is worried about potential mischief and political sideshows. Quite frankly, if
the Federal Reserve decides that it wants to do more quantitative easing, I
would much prefer that Congress authorize the Fed to purchase a few trillion
dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to
do an actual helicopter drop. The infrastructure bonds would create jobs and
give our children something for their future, a much healthier outcome than the
ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative
easing. In those instances, the benefits of QE went primarily to the well-off.
But I digress.

The
reigning academic orthodoxy for central bank believers is Keynesianism. Saint
Keynes postulated that consumption is the fundamental driver of the economy. If
the country is mired in recession or depression, then government and monetary
policy should be geared toward increasing consumption in order to spur a
recovery. Keynes argued that the government should be the consumer of last
resort, running deficits as deep as necessary during recessions. (He also
advocated paying down the debt during the good times, prudent advice roundly
ignored.)

The
current belief in vogue is that another way to increase consumption is to get
businesses and consumers to borrow money and spend it. Hopefully, businesses
will invest it and create new jobs, which will in turn enable more consumption.
One way to stimulate more borrowing is to lower the cost of borrowing, which
the Federal Reserve does by lowering interest rates. The opposite is also true:
if inflation is a problem, the Fed raises rates, taking some of the
inflationary steam out of the economy.

How
would negative rates work? The Federal Reserve would charge a negative interest
rate on the excess reserves that banks deposit at the Fed. Note this is not a
negative interest rate on all deposits, just on “excess reserves” on deposit at
the Fed. An excess reserve is a regulatory and political concept that is a
necessary feature of the fractional reserve banking systems of the modern
world. Banks are required to maintain a reserve of their assets against
possible future losses from their loan portfolios. The riskier the assets the
banks hold, the less those assets count towards the required level of reserves.
Reserves are required to keep a bank solvent. Banks are closed and sold off
when their reserves and capital are depleted below the allowed levels.

Any
reserves in excess of the regulatory requirements are counted as “excess.” The
theory is that if the central bank charges banks interest on their excess
reserves, the banks will be more likely to lend that money out, even if at a
lower rate, in order to at least make something on those reserves. Right now,
banks are paid by the central bank for their excess reserves on deposit. Given
the level of excess reserves at the Fed, these interest payments amount to
multiple billions of dollars that are fed into the banking system each quarter;
and that is one of the reasons why US banks have been able to get healthier in
the wake of the Great Recession.

Consumers
and businesses would borrow this cheaper money from the banks and presumably
spend it or otherwise put it to use, thereby stimulating the economy and
vanquishing the evil of deflation. In theory, as the economy recovers, interest
rates are allowed to rise back above the zero bound.

Of
course that was the theory when we went to zero rates some six years ago. At
some point the economy would recover and the Fed would normalize rates. Except
the economy never got to a place where the Fed felt comfortable raising rates
even minimally – until last December. And now the high priests of the FOMC are
signaling that it might be longer than they originally thought before they
swing their incense orbs and raise rates again.

There
are some (including me) who would argue that, rather than focusing on
consumption, monetary and fiscal policy should focus on increasing production
and income. By lowering (repressing) the amount of income savers get on their
money, you push savers into riskier assets. That is generally not what you tell people to
do with their retirement portfolios, (nor can we overlook the fact that the
country is getting older). Thus if interest rates are artificially low because
of Fed policy, that reduces the amount of money retirees have to spend. The
Federal Reserve and central banks in general seems to think it’s better to have
consumers borrow than save.

It’s a
Keynesian conundrum. If nobody spends and everybody saves, the economy slows
down. While it may be a good thing for you individually to save and prepare for
your retirement, if everybody does so at the same time the economy plunges into
recession.

Now
let’s get back to the intersection of economics and religion. There are
multiple competing economic theories on the government’s role in monetary
policy making. The operative word is theories.
Each is an attempt to describe how to manage a vastly complex modern economy.
Some see too much debt as the cause of our current malaise. Others think that
lowering taxes would allow consumers and businesses to keep more of their
income and hopefully spend it.

In the
not too distant human past, shamans and soothsayers conjured theories about how
the world worked and how to predict the future. Some examined the entrails of
sheep, while others read meaning into the positions of the stars (or whatever
their prevailing theory dictated) and told leaders what policies they should
pursue. An astute priest would pretty quickly figure out that the best route to
priestly job security was to foretell success for the
politician’s/king’s/tribal chief’s pet policy course.

In
today’s world, economists serve exactly the same function. They skry their data
sets – a latter-day version of throwing the bones – and then, based on the
theory by which they believe the data should be interpreted, they confirm the
orthodox policy choices of their political masters – and so their careers
prosper.

This
is not to disparage economists – not at all. They really do try to come up with
the best possible policies – but the range of policy alternatives is
constrained by the economists’ (and the general society’s) belief system. If
you believe in a Keynesian world, then you will prescribe lower rates and more
fiscal stimulus during times of recession.

If, however,
you believe in a competing model, such as the Austrian theory postulated by
Ludwig von Mises, then you believe that smaller government, far less fractional
reserve banking (if any at all), and a gold standard are appropriate. A
recession should be allowed to “clear,” permitting defaulting borrowers to
reduce their debts and putting the assets that collateralized their loans back
on the market at reduced prices, thereby encouraging businesses to employ those
now-cheaper assets in income-producing activities. (This is a very simplified
explanation.)

There
are other competing theories, each with its own model of how the world works.
There is convincing logic and a believable rationale behind each theory. If we
had adopted an Austrian model in 2008–09, we would have had a much deeper
recession and unemployment would have risen higher, but the recovery would
theoretically have come more quickly as prices cleared and debt was resolved.
However, that period of time before the recovery began would have been devastating
to the millions of families who would have faced even more crippling
unemployment than we saw. That is an experiment we did not conduct, so we will
never truly know whether that path might have been less painful in the long
run.

Austrians
are willing to face a series of small recessions as part of the price of
maintaining a free economy, rather than postponing recession and trying to
fine-tune what is supposedly a free market economy by means of monetary and
fiscal policy. An analogy would be the theory that allowing small and
controllable forest fires today might prevent a large, utterly devastating
forest fire in the future. Nassim Taleb’s important book Antifragile
makes a strong case that businesses, markets, and whole societies are much
better off if they allow relatively minor random events, errors, and volatility
to correct as quickly as possible rather than continually patching them over to
avoid short-term pain. Decentralized experimentation in the economy by numerous
complex actors capable of taking risks works better than a directed economy
that encourages the buildup of excessive risk throughout the entire economy.

The
problem is, there really is no one clearly right answer as to which economics
belief system is best. I know what I believe to be the correct answer, but that
belief is based on the way I understand the world – and the world is vastly
more complex than anyone’s theory can be. No theory allows for a perfect
solution for all participants. Rather, each theory picks winners and losers,
with the overall objective of creating an economy that has maximal potential to
grow and prosper.

(Sidebar:
Let me tell you where Bernie Sanders and I agree. He rails against the
privileges of Wall Street, crony capitalists, corporate insiders, and
lobbyists, and the political favors and laws they get passed that benefit them
and not Main Street. The deck is stacked in their favor. In that he is right.
But his and my solutions to the problem are not similar, as he wants to create
even more regulation and taxation, and I would prefer to remove all of the tax
preferences and greatly reduce the regulatory morass that favors large
businesses over small. I don’t want the government involved in picking winners
and losers; that’s the role of the marketplace.)

So
this is what it comes down to: The reigning academic theory/belief system is
Keynesianism. The head Keynesians are signaling that they are going to give us
negative rates. In fact, according to their theory, it would be irresponsible not
to do so. They believe that if they sit back and allow the economy to sort
itself out, the outcome would be far worse than anything that could be wrought
by the intended and unintended consequences of negative interest rates.

We can
differ with those in charge, but the experiment with negative rates is going to
happen, and we need to begin to adjust – to think through how to position our
portfolios and our investment strategies, our businesses, and our lives.

The
Fed is run by True Believers. Just as Christianity or Islam or any other
religion has believers that range across a spectrum of faith and beliefs, so
does Keynesianism. At the Fed, these are deeply held beliefs: our central
bankers are well convinced that the facts demonstrate the validity of their
belief system.

I am
reminded of the apologetics courses that I took in seminary (yes I graduated
from seminary in 1974 – go figure). Apologetics courses basically teach you
reasoned arguments in justification of a particular view, typically a theory or
religious doctrine. We would look for logic and evidence that our particular
version of Christianity was the correct and true position. Apologetics gave us
the techniques and facts that would back us up!

I am
not really trying to equate religion and economics, but I am saying that both
rely on belief systems about how the world works, and that the behavior of
believers is modeled on those systems. Paul Krugman tells us that fiscal
stimulus and quantitative easing didn’t give us enough of a recovery simply because
we didn’t do enough. If we had just believed more, had more faith in the
effectiveness of Keynesian doctrine, we would now be well on our way to the
economic promised land!

The
fact that neither Europe nor Japan nor the United States have seen a recovery –
that much of Europe is either in recession or on the borderline of recession,
that Japan is dealing with severe deflationary pressures, and that the US is
visibly slowing down does not create a question in Keynesian minds with respect
to the correctness and effectiveness of their policies. I believe that both
Japan and Europe are going to double down on quantitative easing and negative
rates in their respective countries, and the US will soon follow.

I am
glad I am not a central banker. The pressure to “do something” in the midst of
a crisis must be horrific. To feel a responsibility and not be able to respond
would be emotionally draining. I do not envy any of them. I think my own
current belief system would probably take us in the optimal direction over the
long term, but I can assure you that in the short term quite a few of my fellow
citizens would not be happy with the process. And whether it is I or the
Keynesians selling a particular theory, promising people pie in the sky doesn’t
help them much to deal with the problems they face here and now.

The
fact is that all of these economic theories have at their core political views
about how the economy should be organized and managed. Including mine. That
doesn’t necessarily mean mine is right and theirs is wrong. To determine the
“rightness” of a theory, you generally try to conduct controlled experiments
that give reproducible results. That kind of gold-standard research is simply
not possible in today’s world. So we actually are forced to rely upon our pet
theories as to how the world works. I am certainly not a believer in moral
equivalency, but until one operative theory is thoroughly discredited (as
communism was) it can remain the controlling theory for a long time.

I have
a lot more to say and will do so in the future, but this letter is getting
overly long, and I need to close it. I leave you with one of my favorite Yogi
Berra quotes: “In theory there is no difference between practice and theory. In
practice there is.” In theory the economy should respond to stimulus, and an
economy that is demonstrably overburdened with debt should be pushed to
increase that debt. In practice, the outcome may not be quite as salutary as
the theory suggests. Adjust your world accordingly.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.